Our analysts perform their own proprietary ESG research. This includes information from conversations with management, and from a company’s annual and sustainability/CSR reports. Our most critical ESG information comes from our on-the-ground immersions research, and from the ethnographers with whom we collaborate. We also receive governance information and recommendations from Institutional Shareholder Services Inc. (ISS).
Before an analyst proceed to detail analysis, they will screen out any companies that they believe their ESG risks are not quantifiable
We believe that investors should be compensated for all risks and not just operational risk. Therefore, ESG integration is critical to any methodology which aims to measure risk-adjusted returns.
All risks are given a qualitative score which is translated into a proprietary forward-looking beta. The beta feeds into a cost of equity calculation, which determines risk-adjusted returns.
The team uses a pre-mortem process to identify and quantify the risks that the company faces. The team imaginatively projects itself three years into the future and assumes that the company has had no growth in earnings. We work backwards to identify the risks that could have caused this future event. Every risk is rated from 1-10 based on 3 factors:
1. How much is the risk priced in?
2. How materially can the risk affect earnings?
3. What is the probability that the risk materialises?
The top 10 risks are then classified into 4 different categories (Strategic, Operational, Financial, ESG). The weighting is therefore not fixed across the universe of stocks, but rather is driven by the size and number of ESG risks that we perceive in each company. When considering ESG from a risk perspective, it is the risk score that dictates the impact on expected risk-adjusted returns more than the timing.
We engage with management on the strategic, operational, financial and ESG risks that the company faces. During our discussions we try to ascertain whether our estimates of probability and materiality for each risk concurs with those of management. We try to understand whether the company's own Internal Audit function has identified these risks, as well as any processes that they have put in place to monitor and control them. We use this opportunity to ask management to bring to their Internal Audit's attention risks that we believe should be included in their risk assessment.
We have adopted this strategy because failure to monitor and control risks increases the overall level of risk, and therefore the cost of equity of a company, reducing risk-adjusted returns to our clients. If we believe that risk-adjusted returns can be improved through better risk management, we are prepared to escalate our action. We explain to management what the impact will be in terms of improvement in their cost of equity if they address specific ESG risks. We highlight to management whose ESG risk control is better than for their peers the positive impact in terms of reduced cost of equity.
Investment decisions also follow the rationale of higher risk scores leading to higher cost of equity, which in turn leads to lower expected risk-adjusted returns. This is at the core of our philosophy.